Last week, the UK Prudential Regulation Authority (PRA) published a consultation paper on group policy and double leverage, in which the PRA wants to limit the risks arising from excessive double leverage.

The consultation paper and the associated speech by Sam Woods received some coverage, though the ECM addendum on Non-Performing Loans probably attracted more attention. Nevertheless, the Double Leverage paper is important, especially in a globalised world.

Two questions that came to mind while reading the paper. Firstly, given that double leverage is such an important issue, why does the Prudential Regulation Authority worry, I mean, today? Secondly, is this a problem that should only make the PRA worry?

Before answering these questions, I will explain double leverage, as it looks like it is not always clearly understood – and I admit I sometimes struggle as well.

Double leverage, a primer. Double leverage happens when a bank borrows money to invest in another bank, and when that bank also borrows money to invest in again another bank. This can go on and on and on, see this picture:

As you will notice, one investment of only 10 supports assets worth 370 (360 mortgages and 10 cash). The resulting leverage ratio is 2.7% (10/370), which today is unacceptably low.

Addressing double leverage is fairly simple: deduct any investment in another bank from equity capital, and presto! Banks will stop investing in other banks. … Just look at the example above: suppose the regulator deducts the value of the investment in Bank 2 from equity capital of Bank 1. That bank then will have no regulatory capital left and will lose its banking license immediately. Facing such a deduction, Bank 1 will not invest in other banks. Problem solved!

All bank regulation has rules that require banks to deduct holdings in other banks from capital.

So, what is then the problem? 

Unfortunately, regulation is not perfect. Rules that entered into force after the GFC harbor some important problems. First is that bank regulation offers exemptions to the main rule of deductions. For example, banks can hold small portions of shares in other banks as long as those holdings do not exceed 10 percent of regulatory capital. (This would make sense. e.g. if a bank invests in bank shares on your behalf.) In addition, Basel III has a special regime for large investments in other banks: for these investments the threshold deductions apply (para 87 of Basel III rules text). These widen the exemptions, thus augmenting the risk of double leverage.

Why these exemptions? Well, full deduction of bank holdings makes it harder for banks to expand, specifically abroad. It puts banks in a less competitive position than other companies, which can invest in other firms.

Capital transferability or not, that is the question. A second problem is the result of the focus of bank supervisors. They predominantly rely on the consolidated balance sheet of a banking group. If you look at the illustration above, then the consolidated balance sheet has assets worth 370 and liabilities worth 360. The resulting capital is 10, and we already concluded that this resulted in a very low leverage ratio value. Applying supervision on a consolidated basis should lead the regulator to require Bank 1 to hold about 37 equity, to satisfy an acceptable capital requirement of 10%.

The problem with supervision on a consolidated basis is that it ignores the location of capital. This is important when banks have subsidiaries abroad. Just think of the following: suppose the parent company of ING Bank N.V. gets into serious trouble, resulting in a severe loss of regulatory capital. Assume that foreign subsidiaries of ING are not affected and are all financially healthy and well-capitalized. Now, the loss of capital at the parent (ING Bank N.V.) will not always be visible at the consolidated level, especially if there are subsidiaries that are well-capitalized; in a way, consolidated information is akin to the tip of an iceberg: it hides anything underneath. Facing bankruptcy, ING Bank N.V. will want to plug its capital hole. It can do so by grabbing capital from its well-endowed subsidiaries abroad.

“Not so fast!” The foreign supervisors will say. They will block such capital transfers, especially if they are meant to prop up a black-hole elsewhere. So, even if at consolidated level everything looks fine, serious problems can arise if capital is not transferable within a banking group: when host supervisors block the payments of dividends to the parent home bank. Capital transferability often breaks down during a crisis, when all supervisors become suspicious about intra-group capital transfers: “Is this to support a bleeder elsewhere in the group?” This compromises the value of supervision on a consolidated basis.

Foreign host supervisors are aware of the capital transferability problem. To protect them from capital-grabbing parent banks in the home country, the foreign host supervisor generally requires the subsidiaries that it hosts to hold much more capital than the regulations require. See the response of the Polish Financial Supervision Authority on the FSB TLAC proposals:

Poland hosts many large foreign banks, so yes, it makes sense to require the subsidiaries of foreign banks to hold more capital. Else its banking system will evaporate in a crisis. However, if all supervisors act like the Polish supervisor, a race to the top will ensue. All supervisors will require banks to hold more capital, just in case transferability breaks down. This would then replace supervision on a consolidated basis by solo supervision, which is surely more prudent, but would make it more difficult for banks to expand.

Beggar thy neighbor. Moreover, and this is the problem that the PRA addresses in its consultation paper: post-Brexit, subsidiaries of British banks in Europe will have to do precisely what the Polish supervisor wants: hold more capital. In practice, this could force UK parent banks to make their subsidiaries issue shares that the parent banks then will buy and hold. In the example below, the Polish subsidiary issues 15 of new equity to meet a capital requirement of 25, set by the Polish supervisor:

The Polish subsidiary is well-capitalized, but look at the UK parent: it funds 15 of equity capital (25-10) with borrowed money. To address this double leverage problem, the UK parent should issue equity capital to cover the requirement of the Polish supervisor: Beggar thy neighbor. Whether this is possible under EU bank rules, is a bit iffy, as there are additional exemptions that frustrate EU regulators’ prudential desires, see below.

Note that Example II also illustrates an artifact of supervision on a consolidated basis: the deductions that I mentioned earlier apply to holdings in non-consolidated subsidiaries. See the Basel III rules text page 25, which rules the deduction of “Significant investments in the capital of banking, financial and insurance entities that are outside the scope of regulatory consolidation.” In many cases, banks own subsidiaries that they consolidate, thus rendering intra-group holdings unregulated, (which footnote 1 of the PRA Consultation Paper seems to ignore).

What about intra-group holdings? Given the flaws of supervision on a consolidated basis, surely a supervisor could watch the home parent banks more closely. In Example II above, the UK supervisor would want to deduct the potentially non-transferable holding of the Polish subsidiary from equity. E.g., assume that the non-transferable part of the holding is 15, then the UK parent bank should issue 15 equity to undo the deduction and to restore its capital ratio. This would solve the problem, even though the UK parent bank will not like this solution: banks do not like to issue equity.

More exemptions? An important problem is CRR Article 49  2. It outlaws deductions of intra-group capital: “For the purposes of calculating own funds (=capital) on an individual basis and a sub-consolidated basis, institutions subject to supervision on a consolidated basis … shall not deduct holdings of own funds instruments issued by financial sector entities included in the scope of consolidated supervision, unless the competent authorities determine those deductions to be required for specific purposes, in particular structural separation of banking activities and resolution planning.” The CRR then applies a 250% risk-weight to holdings in other banks, instead of the deduction. (In the past, this was 400%.) This regulation then allows the foreign (host) supervisor to augment capital requirements at the expense of the capital position of the home parent, thus aggravating the double leverage problem – while the PRA’s hands are tied. See my spreadsheet example, which allows you to play the role of host supervisor and transfer capital from parent to subsidiary.

CRR Article 49  2 is a prudential mishanter, as Sam Woods must have noticed. The PRA now reverts to Pillar 2 to address double leverage, as Pillar 1, due to Article 49 2., is impotent. It will remain so as long as UK banks are subjected to the CRR and as long as UK banks migrate operations to continental Europe.

Answers

Regarding the first question: this has been a problem for a long time, i.e. since it was decided in 2012 that bank holdings could not be deducted under Article 49  2.

I always wondered when supervisors would discover Art 49  2. So yes, I can see why the PRA addresses double leverage, now, as Brexit looms.

Still, and this is a surprise, there is delegated regulation that aims to address the issue of transferability, see here. I wrote about is before.

Regarding the second question: I noticed that my national supervisor, the RBNZ, failed to spot the Beggar thy neighbor problem in their second capital revision paper on which I commented some weeks ago.

Again, bank capital is important and it is disturbing to see a regulator failing to spot basic double leverage problems. However, until last week, the RBNZ was in good company.